The Investment Reporterrecently analyzed 24 oil and gas stocks that are all ‘buys’ or ‘holds’. Of those, it selected only four that it rates as current ‘best buys’. They are Imperial Oil, Encana Corp., Birchcliff Energy and Murphy Oil. Here’s why.

West Texas Intermediate is North America’s oil benchmark. It trades around US$50 a barrel. That’s little changed. No wonder. Higher prices quickly drive up production. This acts to restrain price increases.

OPEC (the Organization of Petroleum Exporting Countries) has reduced its supply to support the price of oil. Other major producers, such as Russia, agreed to go along with this plan. The trouble is, higher oil prices encourage ‘cheating’ (producing more than agreed to). It also makes higher-cost worldwide oil production viable.

Shale oil production quickly adjusts to prices

Many U.S. producers, for instance, use shale drilling to tap previously unavailable energy reserves. It also renews old plays. Shale production has come back quickly as prices rise. This reduces U.S. oil imports. What’s more, the technology continues to improve and to reduce the cost of shale drilling.

Other high-cost production will continue. Consider Alberta’s oil sands. True, lower prices means shelving new oil sands projects. But as long as prices cover the cash cost of producing more barrels, existing oil sands plants will still operate. Similarly, with little else to sell, Russia will keep exporting energy.

Iran wants to rebuild its production to the level it was at before it faced economic sanctions. Likewise, Iraq wants to rebuild its production to where it was at before the American invasion. This should overcome lower production in Nigeria and Venezuela.

Less investment and growing demand

Investment in oilfields has plunged in recent years. That’s likely why the price of oil has partly recovered from a low of just under US$26 a barrel. But higher prices bring back higher-cost producers.

Then again, the world’s demand for oil is expected to grow. That’s because the world economy is expanding. Particularly in the U.S. The world’s largest economy is expected to grow by a healthy 2.3 per cent in 2017. On the other hand, U.S. economic growth requires less oil less than in the past.

The euro area’s economy is expected to grow by 1.6 per cent in 2017. China, the world’s second-largest economy, is expected to grow by 6.5 per cent. Japan, the world’s third-largest economy, by 1.1 per cent—better than last year. And India, by an outstanding 7.2 per cent. All are major oil importers.

Europe would likely embrace imports of North American liquefied natural gas. This would cut their dependence on unreliable supplies from Russia.

In the short- to medium-terms, some fuel consumers will switch to cheaper natural gas if they can. In the long run, the construction of plants to liquefy natural gas for export will eventually alleviate or eliminate the glut of this commodity.

Environmental concern is leading to the development of alternate energy that could compete with oil and gas. Hybrid cars, for instance, use less energy. More important, electric vehicles will require no oil for fuel.

Our oil and gas stocks survey offers advice on 24 producers. We identity four ‘best buys’. We believe that it pays to stick to the strongest producers. They can survive industry downturns and thrive when the industry recovers.

Stick to the four ‘best buys’ from our survey

Here’s how we organized our oil and gas stocks survey. First we looked at each company’s share price, cash flow per share in 2016 as well as expected cash flow per share for 2017.

Then we calculated each company’s price-to-cash-flow ratio for 2016 and its expected price-to-cash-flow ratio for 2017.

It’s best to buy producers with expected 2017 price-to-cash-flow ratios of below five times—or six for integrated companies. Remember, integrated producers are diversified across ‘upstream’ divisions (like exploration), ‘mid-stream’ divisions (such as refining) and ‘downstream’ divisions (such as gas stations). This stabilizes their profits and reduces their risk.

Estimating future cash flow is difficult. That’s partly because so many factors affect oil and gas prices. As a result, estimating cash flow per share is uncertain. Also, changes in the number of shares outstanding affect cash flow per share. When a producer issues shares, cash flow per share will decline, all else being equal. When producers buy back their shares, cash flow per share will rise, all else being equal. But share repurchases among oil and gas producers are less common than in some other industries. A producer may use cash flow to raise its dividend, repay debt and invest for future growth.

Transportation of oil by railroads has supported oil prices and the cash flow of Canadian producers. We put heavy reliance on expected price-to-cash-flow ratios. After all, they’re forward-looking and include expected future commodity prices. Of our ‘best buys’, U.S. oil producer Murphy Oil (NYSE—MUR) beats its share price-to-cash-flow criteria of six times or less. Imperial Oil (TSX—IMO) is moderately above six times. Encana Corp. (TSX—ECA), is above the threshold of five times. Birchcliff Energy (TSX—BIR) is also above, with a forward price-to-cash-flow ratio of 5.4 times. These four ‘best buys’ look better than most of their peers.

We exclude from our ‘best buys’ most producers that significantly miss the required share price-to-cash-flow ratios. We exclude, for instance, integrated oil producer Suncor Energy (TSX—SU) from our ‘best buys’. While it remains a ‘buy’, it trades at a somewhat high price-to-cash-flow ratio of 10.6 times.

Look for cash flow growth of 20 per cent

Cash flow growth indicates low operating expenses and growing production. We usually prefer cash flow growth of 20 per cent or more, especially for junior and small producers. This 20 per cent rule doesn’t apply to integrateds, however, because their midstream and downstream operations can hold back their cash flow growth.

All four of our ‘best buys’ achieved cash flow growth of over 20 per cent: Imperial Oil (68.5 per cent), Encana Corp. (42.9 per cent), Birchcliff Energy (60.9 per cent) and Murphy Oil (53.8 per cent) greatly exceeded this criterion. Just keep in mind that Imperial Oil’s one-time sale of gas stations increased its cash flow. It can’t sell them again, of course.

Despite oil-by-rail, a lack of pipeline capacity depresses the prices of bitumen and crude oil from Western Canada. Western Canadian Select always trades below benchmark West Texas Intermediate crude. This can hold back the cash flow growth of oil sands producers.

Return on assets or earnings divided by total assets

This ratio shows how much a company earns on each dollar of assets. The higher the return on assets, or ROA, the better. A high number shows that management has made good use of financial leverage. A high ROA can also give a company the financial flexibility to keep investing and growing. Imperial Oil and Encana Corp. generated an ROA. So did Murphy Oil. But all the junior producers and even some of the U.S. integrateds and Brazilian Petrobras (NYSE—PBR) are expected to have no returns in 2017. With no return, there’s no ROA, of course.

What percentage of a company’s production is oil?

It costs less to produce natural gas than oil. That’s why companies that focus on gas can profit greatly when gas prices are high. But gas producers suffer when gas prices lag, as they’ve mostly done since 2009. In fact, that’s largely why Encana Corp. sold natural gas assets and bought oil assets. Production balanced across both oil and gas protects against a sharp drop in the price of one commodity.

How well can a company manage its debt?

For Canadian producers, we start with net debt, or a company’s total short- and long-term debt less its cash and short-term investments. Then you divide the result by its cash flow over the latest four quarters. For foreign producers, we divide their expected long-term debt by their expected cash flow. We prefer producers with net-debt-to-cash-flow ratios of two times or less. None of our four ‘best buys’ meets this criterion—though Murphy Oil comes close at 2.1 times. With solid cash flow growth, our ‘best buys’ face little financial risk from debt.

When a producer’s net-debt-to-cash-flow ratio significantly exceeds two times, it faces more risk. That’s because a sudden drop in commodity prices would cause these ratios to deteriorate further. At that point, high debt could cause problems. The cyclical oil and gas industry is subject to such sudden drops in prices, of course.

We adjusted the net debt-to-cash-flow ratios of some Canadian producers. For instance, We added the debt that Cenovus Energy (TSX—CVE) took on to expand its operations in Alberta’s oil sands. Asset sales or the issuance of shares strengthens balance sheets.

When debt ratios are high, remember that commodity prices will eventually recover. This, in turn, will raise the cash flow and reduce the debt-to-cash-flow ratios of most producers.

When a company makes a big acquisition, we may calculate its net-debt-to-equity ratio: while the acquisition immediately adds to the debt, it takes a year before the cash flow becomes meaningful.

Operating margins: Can a company’s keep its costs down?

We calculate this ratio by dividing a producer’s operating income by its oil and gas revenue. Operating income is also known as EBIT, or Earnings Before Interest costs and income Taxes. We don’t use the usual EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization for resource companies. That’s because of their high depletion costs. (Depletion of resources is like depreciation).

We favour producers with operating margins of at least 20 per cent. Of our four ‘best buys’, Encana Corp. (42 per cent) and Murphy Oil (45 per cent) greatly exceeded this criterion.

Our advice on each stock

These indicators can help identify attractive producers. But even those with favourable numbers may be ‘holds’ or ‘sells’ if their shares prices are too high. Based on the above indicators and their prospects, our three Canadian ‘best buys’ are integrated oil company Imperial Oil, senior producer EnCana Corp. and junior producer Birchcliff Energy.

A higher loonie can hurt the results of Canadian producers. So our ‘best buys’ also includes U.S. integrated oil company Murphy Oil.

Remember to diversify among oil and gas stocks

With 14 of the 23 producers in our oil and gas survey rated ‘buys’, it may appear difficult to decide how to structure your portfolio to include oil and gas stocks. Here are a few suggestions:

1) Diversify globally. Choose first from among the U.S. and international producers. We chose American integrated oil Murphy Oil, for exposure to global opportunities.

2) You should usually buy a Canadian integrated company. Imperial Oil is now the ‘best buy’ of the four, although Suncor Energy and Husky Energy (TSX—HSE) remain buys.

3) Diversify among oil producers and natural gas providers. Imperial Oil and Murphy Oil focus on oil. For diversification purposes, you should also buy a producer that focuses on natural gas. Our choice for ‘best buy’ is Birchcliff Energy.

This is an edited version of an article that was originally published for subscribers in the April 14, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.